Equilibrium Selection in Pure Bubble Models by Dividend Injection

Abstract

Rational pure bubble models feature multiple (and often a continuum of) equilibria, which makes model predictions and policy analyses non-robust. We show that when the interest rate in the fundamental equilibrium is below the economic growth rate ($R<G$), a bubbly equilibrium with $R=G$ exists. By injecting dividends to the bubble asset that grow slower than the aggregate economy, we can eliminate the fundamental steady state and resolve equilibrium indeterminacy. We show the general applicability of dividend injection through examples in overlapping generations and infinite-horizon models with or without production or financial frictions.